There are several ways to broaden or limit indemnification provisions in your purchase and sale agreement. We discuss a few of the tools (caps, baskets, carve-outs, and escrow accounts) below.
Indemnification provisions can expose both parties to unlimited liabilities and risks. One indemnification tool is an indemnification cap. Indemnification caps are contractual provisions that limit the maximum amount of liability or damages that a party can claim. The caps serve as a protection for the indemnifying party by putting a ceiling on the amount they would be liable for. Caps provide:
- Predictability and certainty.
- A “budget” for the indemnifying party.
- Each party the ability to plan for the future.
- A way to balance risk and rewards in relation to the risk a party is taking on.
Remember, buyers will typically want a higher cap to ensure that they are adequately protected, while sellers will want a lower cap to limit their costs.
Baskets are another tool where a threshold amount must be exceeded before any indemnification obligations kick in. Think of it almost as a deductible. The basket amount can be expressed as a fixed dollar amount, a percentage of the contract value, or even a combination of both.
By setting a threshold amount, indemnification obligations are triggered only in cases where the potential liability is significant enough to warrant it (Basket 1), while also avoiding the possibility of being inundated with many small claims (Basket 2).
Carve-outs are exceptions to the indemnification provisions that exclude specific types of claims or liabilities from the indemnifying party’s obligations, a set cap, or set basket. For example, a seller might carve out claims arising from a specific type of liability, such as environmental contamination, which means that the buyer would assume all responsibility for any environmental liabilities related to the target company regardless of caps or baskets. Carve-outs can be a useful way to limit indemnification obligations, but they must be carefully defined and understood by both parties and there should be no room for interpretation or dispute.
While limiting the amount of indemnification can be one focus, parties can also provide assurances with an escrow account. An escrow account is a holding account for funds that is managed by a third party, typically an escrow agent or attorney. In a merger and acquisition (“M&A”) transaction, an escrow account can be used to hold a portion of the purchase price that is reserved for indemnification claims. The funds in the escrow account are held for a specific period after the transaction closes and are used to satisfy any indemnification claims that arise during that period.
The use of an escrow account for indemnification has several benefits:
- It provides a source of funds to cover indemnification claims by setting aside a portion of the purchase price in an escrow account, the buyer has a source of funds to cover indemnification claims that arise after the transaction closes.
- It can help to build trust between the parties by providing a mechanism for resolving disputes and ensuring that indemnification obligations are fulfilled.
However, it’s important to note that the use of an escrow account for indemnification does have some drawbacks:
- It can tie up a significant amount of funds for an extended period of time.
- It can create additional costs and administrative burdens because the parties typically have to compensate the escrow agent for costs including legal fees, bank fees, and ongoing management of the account.
In conclusion, the use of an escrow account for indemnification can be an effective way to manage the risks and uncertainties associated with M&A transactions. However, it’s important to carefully consider the costs and administrative burdens associated with the use of an escrow account and to ensure that it is structured in a way that is fair and equitable for both parties.
Each of the above tools can be used to broaden or limit the scope of indemnification provisions in purchase and sale agreements. They are tools to be considered by the buyer and seller when approaching how to distribute the risk from damages or loss that were not accounted for directly in the purchase and sale agreement.
The above article is for general information purposes only and should not be relied upon as specific legal advice. This article, or contacting Apex, does not in any way form an attorney-client relationship. If you have any questions or would like to learn more, please contact Tara Vitale at email@example.com or visit our blog. You might also like to read, “The Crucial Work Lawyers Do When You Buy a Business.”